Power of Ideas

Building Markets

By Iftikhar Tari, Christopher Legilisho, Stephen Birungi, and Najia Ubaid with Carole Biau

IFC-Milken Institute Capital Markets Program trains mid-career policymakers in emerging and developing economies. Program alumni span 23 countries, laying the groundwork for robust capital markets and a healthy business environment in the fastest-growing parts of the world. As part of the program, select groups of alumni are presenting innovative policy ideas at the 2018 Milken Institute Global Conference. What follows is an interview with one of those groups.

Q. Carole Biau, Director of the IFC-Milken Institute Capital Markets Program: Tell me about the policy innovations you’re suggesting to increase access to financing for small- and medium-enterprises (SMEs) across your three home countries.

A.Iftikhar Tari, State Bank of Pakistan (Class of 2018): We are proposing three investment funds for SMEs, tailored to each country. This should help bring SMEs out of the missing middle. Currently, these companies are locked out of microfinance, but larger banks in our countries are very risk-averse and won’t lend to them. Additionally, SMEs can’t reach the suite of financial services available to larger corporates. Our funds would bridge the gap between SMEs and capital markets.

A.Christopher Legilisho, Central Bank of Kenya (Class of 2017): These market-based funds would provide a pool of patient capital. It’s different from what our governments have tried in the past. Kenya has set up government-backed funds for youth and women entrepreneurs and others dedicated to the agriculture and technology sectors— but public financing isn’t enough, and the incentives don’t always line up. We also launched an SME segment on our stock exchange, but demand hasn’t picked up. Pakistan tried the same thing and hasn’t had a single listing. So together, we’re tackling the problem from a new angle.

Q. Carole: Why is this a priority today?

A.Iftikhar: In Kenya, Uganda, and Pakistan, SMEs provide over 80 percent of employment and 20 to 35 percent of GDP. SMEs also contribute 25 percent of Pakistan’s export earnings. Our countries are all in transition: they aspire to reach middle-income status, and SMEs are the key for getting there. 

A.Stephen Birungi, Bank of Uganda (Class of 2017): There’s also a real demographic threat. Uganda is the world’s second-youngest country, with a median age of 15.5. Where will employment come from for our young people? Will this just mean more emigration? SMEs are the main source for jobs. That’s where policymakers should focus.

Q. Carole: How would small companies benefit from your proposed fund structure?

A.Stephen: Even when banks are willing to lend, interest rates can be as high as 20 percent in Uganda. Banks want to be repaid quickly, whereas SMEs might start out cash-flow negative. A tailored fund would help on both fronts: it would bring down SMEs’ cost of capital by widening their potential investor base, and this patient capital would give companies more time to grow and reach positive cash-flows. 

A.Najia Ubaid, Pakistan Securities and Exchange Commission (Class of 2018): SMEs participating in these funds would have to enhance their corporate governance and financial reporting standards, which can improve efficiency. Additionally, companies with more equity on their balance sheets have more space to take some risks and innovate.

Q.Carole: What would investors get out of the fund?

A.Najia: As regulators, we prioritize investor protection. The fund structure allows us to diversify and tranche risk, which helps protect investors and match their risk appetites. More specifically, we would back Pakistan’s SME fund with collateralized loan obligations. The SME loan portfolio would be transferred to a special purpose vehicle in three tranches (senior and mezzanine for institutional investors and banks, and an equity tranche, 95 percent of which would be purchased by the SME credit fund and 5 percent by commercial banks underwriting the SME portfolio). Different risk tiers appeal to a wider range of investors.

A.Stephen: Investors would also benefit from the funds’ local knowledge: local SME deals are usually difficult to source and too small for large international investors— but once identified and pooled, they can become extremely attractive.

Q. Carole: So, what are some top investment opportunities?

A.Chris: We see opportunities across an array of sectors. Kenyan SMEs are increasingly active in agribusiness, construction, manufacturing, and logistics. Life expectancy has also been improving, so the middle class is looking for higher- quality services—that opens up education, health care, and entertainment. The potential is most obvious when we look at companies that have already bridged the missing middle—they’re flourishing. I know a pastry chef who envisioned turning his deli into a brand. He initially self-financed but when he needed to buy out an existing restaurant, he obtained long-term capital from a pioneering development financier. He didn’t have collateral and would never have obtained that kind of financing from a bank. He now runs two very successful chain restaurants in Nairobi.

A.Najia: Each of us has life-changing stories. A family friend started with a small restaurant and now runs a chain across all of Punjab, employing hundreds of people. These are great investments—the returns aren’t just on equity, but also on our populations’ employment and prosperity.

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Iftikhar Tari, Christopher Legilisho, Stephen Birungi, and Najia Ubaid with Carole Biau